Who's Winning the Toy Wars

"Smurfs" scored big at the box office, but that was just the beginning of its revenue push as licensed merch becomes more critical and studios search for the secret to extending a franchise's shelf life.

Look for a crush of little blue characters -- say, a plush 14-inch talking Clumsy Smurf wearing a designer T-shirt -- to invade the holidays this year. As The Smurfs did better at the box office than anticipated, Smurf toys have been dancing into consumers' carts. "Smurfs is selling through very well," says Jeremy Padawer, executive vp marketing and business development at Jakks Pacific, the Malibu-based toy manufacturer with the master license for The Smurfs.

Competing against two of the biggest toy-related franchises ever -- Cars and Transformers -- Smurfs has broken out in what is arguably the most competitive summer in movie history for blockbuster family movies that generate domestic and international licensing and retail merchandising revenue. This summer served up 17 films that amount to toy business bait, including Thor, Captain America: The First Avenger, X-Men: First Class, Pirates of the Caribbean: On Stranger Tides, Green Lantern and Winnie the Pooh -- up from the 10 or so in previous summers.

Jakks Pacific, with revenue last year of $747 million, competes against industry giants Mattel and Hasbro (with $5.9 billion and $4 billion in 2010 sales, respectively). The largest merchandising program in history is being staged for Cars 2 by Disney, which expects the Pixar movie to surpass the Toy Story 3 licensing bonanza last year of $2.8 billion sales and to eclipse Star Wars: Episode III -- Revenge of the Sith record in 2005 of $3.5 billion in retail. Meanwhile, Hasbro is making a competitive marketing blitz for Transformers: Dark of the Moon with 350 licensees, well above the 250 for Transformers: Revenge of the Fallen in 2009.

The nostalgia-driven success of Smurfs could be the kind of holy grail for the licensing world that all these franchises are seeking. It's the moment when the franchise becomes timeless and the toys continue to move independent of box office.

Those few franchises are the only ones that Lego looks to license for the "construction category." Their current lineup includes Harry Potter, Pirates of the Caribbean, Cars, Toy Story, Winnie the Pooh and Star Wars, the reigning king of toy licenses.

"We're taking properties that don't rely on the box office because the peaks and valleys that come with that kind of business model are pretty tough to manage," says Michael McNally, Lego's U.S. brand relations director. "We look for properties that have a timeless quality attached to the characters."

No property in the modern era better exemplifies sustainability than Star Wars, which remains a top seller even though there hasn't been a new movie since 2008 (although there have been new TV shows). Research firm NPD ranks Star Wars as the fourth-biggest seller this year and the top movie license entering summer. "Year in and year out, Star Wars is popular," says Toys"R"Us senior PR manager Bob Friedland.

Summer is only the opening salvo in the toy wars. About two thirds of the year's business will be done after Labor Day, mostly in December. This summer, the biggest displays in Kmart, Target, Wal-Mart and Toys"R"Us have been for Cars 2 and Transformers.

The success of Smurfs, however, signals retailers how to prepare for the holidays. That is why by Christmas, Papa Smurf and Smurfette expect to be sharing more shelf space and front-of-store visibility with Lightning McQueen and Bumblebee the Autobot.

The stakes are huge. NPD says licensed toys and games generated $6.3 billion in retail sales through the beginning of July, a 1 percent increase from the same period a year ago.

The results this summer have already boosted Hasbro and Mattel, which both credit movie-related sales for higher second-quarter 2011 financial results. For the full year, analyst Edward Woo of Wedbush Securities estimates Transformers will add $700 million in sales to Hasbro, and Cars 2 will pad Mattel revenue by $500 million.

It used to be that toy sales were gravy for studios like Paramount, Sony and Disney. But these days, licensing can be as lucrative as the box office, and producers count on that to cover costs that often exceed $150 million.

"Licensed merchandising is no longer a sideshow," says Kerry Phelan, head of consumer products for DreamWorks Animation and formerly of Pixar. "It is now part of a business problem, and whatever they count on has to be there in order to get the revenue needed to cover the issue, expense and all this marketing."

The shift in the role of licensing can be traced to 2000, when Disney established a franchise management team, a move Andy Mooney, chairman of Disney Consumer Products Worldwide, said at an investors conference in February was "truly a game-changer." Mooney said that was when Disney began a "uniquely active approach to licensing."

What he means is that until 2000, Disney had just focused on deal-making while providing minimal input. "Passive licensing is a highly efficient business model in terms of [profit] margin," Mooney told investors, "but it's also highly ineffective at creating sustained growth."

So Disney with Cars 2 was actively managing not just the licensing but also the creation of more than 300 toys, down to the product mix at key retail outlets. For Toys"R"Us, for example, they coordinated 20 different licensees to provide 70 exclusive items.

This aggressive form of product line management, Mooney said, is "unique to entertainment industry licensing, and it has really been a key contributor to growth at [Disney] over the last decade."

For Cars 2, that meant creating characters that serve the movie but also work for retail. "They did an amazing job inventing that world for us," says Doug Wadleigh, Mattel's senior vp global entertainment. "Within the film, there are more than 600 new characters, many in the background, but they provide a wealth of opportunities to create toys from."

Toy and game royalties averaged 9.4 percent last year, according to Licensing Letter publisher Ira Mayer. "Cars 2 is going to get several points beyond that because they can command a premium," Mayer says. (Stifel Nicolaus estimates Cars 2 commanded a lofty 15 percent.)

That premium is largely because the brand will continue even after the movie is released in theaters and on home video. By Disney's estimate, since the original Cars in 2005, consumer product sales have exceeded $10 billion -- before Cars 2.

Not every movie becomes a franchise, as Smurfs aspires to be, and some even fail to generate toy sales. The Universal release Hop sold movie tickets at Easter but not many licensed toys. Universal's 1990 Jetsons feature famously grossed only $20 million domestically despite name recognition, huge marketing, fast food tie-ins and extensive licensing. Retailers who made a huge bet on the associated toy line upfront bore the brunt of the losses.

Another disappointment was the early sales of Harry Potter toys. All the movies in the franchise, which launched 11 years ago, have been huge hits, but Warner Bros. stopped licensing kids' toys after the third movie, Prisoner of Azkaban in 2004. It dropped licenses with Mattel and trading cards from Hasbro and now says that the content of the movies had "aged up" and was no longer for little kids.

So now Potter-mania is aimed at those seeking high-end collectibles (including art, figurines and prop replicas) to adult collectors. So you can find Potter collectibles at FAO Schwarz -- from scarfs, lunch boxes and hats to Hogwarts Castle for $149.99 -- but not as much at Toys"R"Us (which owns FAO Schwarz).

Some movies limit licensing to cater to the target audience. DreamWorks Animation had success this year with Kung Fu Panda 2 without licensing construction toys, for instance.

DreamWorks saw stuffed animals from Mattel's Fisher Price division as "a natural extension of what we know fans love," says Phelan. "We know they are going to want to take home a piece of the movie, and our films have the benefit of being largely unisexual and equally exploit in gender appeal, so we obviously do figural play so boys can live out the action. Girls may want a more cute cuddly plush toy."

Green Lantern fell below expectations in theaters, but toy sales were robust. "Kids don't worry about what's doing well at the box office," said Friedland, who says the film benefited from years as a comic book. "They just want to play with toys made for characters they like. You also have collectors interested in these toys."

Now that Smurfs has exceeded expectations, Jakks is trying to meet the demand from retailers and strategize how to make it into a franchise with legs. The surprise success presents a logistical challenge. "Chasing it right away is really difficult for a manufacturer," says Padawer, "because it takes 100 days to order materials and another 20 days to ship it from Hong Kong."

The goal of creating a lasting franchise is what drives Hollywood and retailers. "Clearly we want to maximize the property when it's on the big screen," says Mattel's Wadleigh, "but it's more important for us to bring our brand management skills to it to make sure that brand, that property, stays on the shelf long after."